Credit Risk Management Practice Exam

In Credit VaR calculations, what does the term “expected loss” refer to?

1. The total loss predicted under worst case scenarios

2. The average loss anticipated from defaults

3. The loss not covered by the Credit VaR

4. The minimum loss expected over a year

The correct answer is: The average loss anticipated from defaults

In Credit VaR calculations, the term "expected loss" specifically refers to the average loss anticipated from defaults. This concept is critical in credit risk management as it estimates the mean value of potential losses due to borrowers defaulting on their obligations over a given period. It reflects the likelihood of default and the financial impact it may have, thus providing a baseline estimate for credit risk exposure. Expected loss is calculated based on historical data regarding default rates and the loss given default, which encompasses the amount expected to be lost if a default occurs, taking into account any recoveries that may be realized. This measure differs from other loss metrics such as total losses in worst-case scenarios, which are typically associated with unexpected losses, or minimum losses over a period, which do not capture the average expectation of losses. By understanding expected loss, risk managers can better allocate capital reserves, price credit products appropriately, and establish risk mitigation strategies, ensuring that the financial institution maintains sufficient resources to cover anticipated losses from credit defaults.